The Governor of California
President pro Tempore of the Senate
Speaker of the Assembly
State Capitol
Sacramento, California 95814

Dear Governor and Legislative Leaders:

As requested by the Joint Legislative Audit Committee, the California State Auditor presents this audit report concerning the costs of the Cigarette and Tobacco Products Tax Program (tax program) and the Cigarette and Tobacco Products Licensing Program (licensing program) administered by the State Board of Equalization (board). Excise taxes on cigarettes and tobacco products fund early childhood development, smoking prevention, and environmental programs, among others. The board’s tax and licensing programs collect and enforce these excise taxes.

This report concludes that although the board’s enforcement efforts are effective and properly funded, other funding options and cost saving measures exist for the licensing program. In 2004 the board implemented the licensing program and began licensing all entities involved in the sale of cigarette and tobacco products in California, with a goal to inspect annually 10,000 of these licensees. In 2005 the board’s tax program put into use an encrypted cigarette tax stamp. According to the board’s most recent estimate, in fiscal year 2012–13 the board’s three-part approach to enforcing compliance with California’s cigarette and tobacco products excise tax laws—licensing, inspections, and an encrypted cigarette tax stamp—prevented the loss of $91 million in tobacco tax revenue.

In addition to using an encrypted tax stamp, the requirement that retailers, distributors, wholesalers, manufacturers, and importers of cigarettes and tobacco products be licensed is a fundamental component of the board’s enforcement effort. However, since fiscal year 2006–07, license fees have not covered all of the licensing program’s costs. For example, in fiscal year 2014–15 licensing fees contributed only $1.8 million of the $9.8 million needed to administer the program. To make up the program’s $8.0 million shortfall, the board uses money from the four funds that receive cigarette and tobacco products taxes. Although it is legally permissible to use excise taxes to fund the licensing program, the board has accumulated an excess amount of unspent license fees that it could use to offset the shortfall. Furthermore, there are several options to address the licensing program’s funding shortfall, eliminate the excessive unspent license fees, and maximize the funding for the programs of three of the four tobacco tax funds that support the licensing program. These options include a combination of retailer, wholesaler, and distributor license fee changes and increases, as well as a cigarette tax increase.

Finally, the board’s method for identifying costs associated with each program is reasonable; however, it incorrectly derived some of its time charges which are the basis of some of its cost allocations. As a result, there was a misallocation of costs among the board’s programs, which we were not able to quantify. Also, because of a decline in the number of licensees, we estimate the board could save $360,000 annually by conducting the same frequency of inspections as it did when it set up the licensing program. We believe conducting fewer inspections would not compromise excise taxes enforcement outcomes.